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AIG's Subprime Bonds Up for Sale

Source: WSJ

Posted on 07 Feb 2012

Five Wall Street banks have been invited to bid this week for another multibillion-dollar bundle of risky mortgage bonds held by the Federal Reserve Bank of New York as a result of its 2008 rescue of American International Group Inc.

The invited firms are the U.S. securities arms of Barclays PLC, Credit Suisse Group AG, Goldman Sachs Group Inc., Morgan Stanley and Royal Bank of Scotland PLC, according to people familiar with the matter. They said the New York Fed is seeking bids by midweek for residential mortgage-backed securities with an unpaid principal balance of $6 billion, or about half the remaining bonds in a vehicle called Maiden Lane II.Selling the bonds would let the New York Fed take advantage of buoyant market conditions to dispose of more troubled assets from the financial crisis.

It also would bring the central bank closer to ending a controversial chapter of its support for financial markets since 2008.

A sale could take place as soon as Wednesday, the people said, if the New York Fed and its investment manager, BlackRock Solutions, feel the winning bid represents good value for U.S. taxpayers. Representatives of the New York Fed and the banks declined to comment Monday on the coming auction.

In mid-January, Credit Suisse bought bonds with a principal value of $7 billion from the regional Fed bank following a similar exercise, in which the Swiss bank's U.S. unit won out over bids from Barclays Capital, Goldman and Bank of America Corp.'s Merrill Lynch securities arm. Credit Suisse quickly resold the securities to investors including hedge funds, insurers and real-estate investment firms.

The Maiden Lane II securities consist mostly of bonds backed by subprime home loans. They had a fair value of roughly 49 cents on the dollar at the end of December, according to Fed data.

Market prices of many residential mortgage-backed securities rose in January for the first time in four months, according to data from Amherst Securities Group. An index that tracks prices of subprime bonds has gained 17% this year, and traded at 51 cents on the dollar on Monday afternoon, according to data provider Markit.

While many subprime bonds aren't expected to recover their full face value because of high loan-default rates, investors are again warming to the securities. The bonds' beaten-down market values already have priced in a weak outlook for housing, and their fat yields are particularly attractive amid the low-interest-rate environment, say analysts.

"Implicit in the view is that we're closer to the bottom in housing, and high default rates are already baked into the prices," says Gyan Sinha, a partner at fixed-income hedge fund KLS Diversified Asset Management LP. "Real estate is still expected to decline, but I don't think most people are expecting double-digit declines" from current levels, he adds.

The New York Fed's sales of large pools of bonds are a change from its auctions last year of individual securities from Maiden Lane II. Those auctions helped trigger a tumble in market prices of structured-finance assets, including commercial-mortgage debt. The selloff prompted the New York Fed, run by President William Dudley, to halt the sales in June.

The New York Fed originally took on residential mortgage bonds with an unpaid principal balance of about $40 billion in the rescue, from an AIG business known as securities lending.

At the time, the central bank provided a $19.5 billion loan to Maiden Lane II to purchase the securities at discounted prices, with AIG providing an added $1 billion. The Fed's loan balance is below $7 billion now, following last year's sales and interest and principal payments it received from the bonds. After the Fed's loan is repaid, AIG—led by CEO Robert Benmosche—will get the next $1 billion. Any further profits will be split between the New York Fed and the insurer, with the bulk going to U.S. taxpayers.